A basic guide to ISAs

Published by Sam Barrett on 14 December 2007.
Last updated on 24 August 2011

I'm interested in ISAs - tell me the basics.

Whether you're saving for something specific like a wedding or house, want to generate a regular income from bonds and fixed-interest products, or are seeking to profit from some of the world's more exotic stockmarkets, then an ISA should be your first choice when looking for an investment or savings vehicle.

ISAs were introduced in April 1999 as the Labour Government's successor to personal equity plans (PEPs) and tax-exempt special savings accounts (TESSAs). Not investments in their own right, ISAs are wrappers that can be placed around a diverse range of investments including savings accounts and stocks and shares.

In spite of the new name and several rule changes, the fundamental benefit of this investment vehicle has remained the same - tax-efficiency. Anything you place inside an ISA wrapper is exempt from income and capital gains tax. Growth of investments inside an ISA is also tax-free, although the changes to taxation of company earnings in 2004 slightly diminished this benefit for ISAs investing in stocks and shares.

From April 2004, fund managers were unable to reclaim the 10% tax credit on dividends. For higher-rate taxpayers there is still a tax saving but, with the loss of the tax credit, basic rate taxpayers pay exactly the same tax on dividends as they would have if they'd held the investment outside the ISA wrapper.

Although this has taken some of the shine off ISAs, they still offer significant tax advantages. In particular, interest on cash is received gross and any investments are exempt from capital gains tax. Even if you're not a taxpayer or are worried about capital gains tax, you should consider an ISA. Your circumstances may change, making previous years' ISAs an invaluable tax shelter for your money.

The different types

There are two types of ISA - the cash ISA, and the stocks and shares ISA. The most popular option, cash ISAs are offered by banks and building societies and are essentially tax-free savings accounts. Interest is paid regularly, so your money is guaranteed not to reduce in value. As with ordinary savings accounts, rates vary substantially.


While there are plenty of great deals available, there are also lots paying dismal rates of interest. The accounts also share many of the features of standard savings accounts, including bonuses, fixed rates, notice periods and penalties. As a result, you need to think about how much access you'll need to your money, before making your choice.

The other type of ISA is the stocks and shares ISA. These can invest in a wide range of assets, including authorised unit trusts and open-ended investment companies (OEICs), investment trusts, gilts (providing they have a term of at least five years remaining) and shares. Unlike their predecessors, PEPs, there are no geographical restrictions on where you can invest.

The most common form of stocks and shares ISA is one that invests in a collective investment such as a unit trust or investment trust. With these you benefit from diversification, as well as the expertise of a fund manager, who will make investment decisions on your behalf.

Alternatively, if you prefer more control over your investments, you could choose a self-select stocks and shares ISA. These allow you to pick the shares you want to invest in and when you want to invest in them, making them ideal for those buying shares on a regular basis.

You should also be aware of stakeholder ISAs. An ISA gains the stakeholder product label if it meets certain conditions set by the Government.

For cash ISAs, there must be no charges, the minimum deposit must be £10 or lower, and you should be able to pay into your account by cash, cheque, direct debit, standing order or BACS. Also, the interest rate must never be more than 1% below the base rate and you must be able to make unlimited withdrawals, with the money available within seven days.

For stocks and shares ISAs, two stakeholder products apply - the medium-term investment product and the smoothed medium-term investment product (which works in a similar way to with-profits to smooth out returns). These products also need to meet certain criteria, including a minimum investment of £20 or less, an annual charge of 1.5% or less for the first 10 years, with a charge of 1% thereafter. Most importantly for cautious investors, no more than 60% of the fund can be invested in shares.

How much you can invest

You can invest up to £7,200 into ISAs every tax year. Withdrawals are permitted, but once you've taken the money out of your ISA you cannot replace it unless you still have some allowance remaining. However, exactly how you invest this money is being simplified. New rules announced in the 2007 budget by Gordon Brown came into effect in April 2008 and aimed to remove some of the confusion surrounding ISAs.

Previously there were mini ISAs and maxi ISAs. Mini ISAs were either cash or equity while a maxi ISA combined the two. However the set-up was considered confusing so mini and maxi ISAs were scrapped in April 2008 and replaced by cash ISAs and stocks and shares (or equity) ISAs.

At the same time the tax free allowance for every UK adult was raised from £7,000 to £7,200 although a maximum of £3,600 can be saved in a cash ISA.

Other changes include the scrapping of Personal Equity Plans or PEPS which were the forerunners of ISAs. Existing PEPs became stocks and shares ISAs and subject to exactly the same rules and tax breaks.

The other important change was the ability to transfer money held in cash ISAs into stocks and shares ISAs. This will allow you to start your savings in a cash ISA, if you don't want to risk them on the stockmarket, and then roll them over into stocks and shares ISAs when you've built up a larger fund and are happy to take the risk.

Unfortunately, however, this won't work the other way round, although the ability to switch out of equities and into cash would be useful for older investors looking to reduce the risk of their portfolio in retirement.

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